Dirty Secrets

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Today the financial world is up in arms over “toxic assets,” the bad loans and securities that have wreaked so much havoc on bank balance sheets. But few investors understand the true magnitude of the threat that toxic liabilities — environmental liabilities, that is — pose to the financial health of some U.S. businesses. In large part that’s because accounting rules enable companies to conceal the full extent of these costs, encouraging minimal disclosure — even when management knows the total bill will be far higher.

It’s no secret that many companies have expensive toxic liabilities — asbestos, heavy-metal pollution, oil and gas leaks, contaminated groundwater, and more. Since the 1970s, Superfund and other laws have required companies to clean up their environmental liabilities and undo the damage they caused. Nor is the primary accounting guidance for toxic liabilities new. FAS 5, the accounting standard governing so-called contingent liabilities, such as pending litigation and environmental hazards, went into effect in 1975; Statement of Position 96-1, which tells firms how to apply FAS 5 to mandated environmental remediation, was issued in 1996. In brief, companies with toxic liabilities must take a one-time charge to earnings and create a reserve of funds devoted to environmental remediation. As a cleanup progresses, the reserve should shrink.

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Yet companies are regularly topping up their environmental reserves with new accruals. Some reserves are even growing. In a recent study of 24 oil, gas, and chemical companies, the vast majority reduced their reserves less than 50 cents for each dollar spent on cleanup, says environmental attorney Greg Rogers, a CPA and president of consulting firm Advanced Environmental Dimensions. (See “The Truth about Reserves” at the end of this article.)

As a result, investors are left in the dark about the full extent of toxic liabilities. Rogers compares environmental reserves to a bathtub full of water: once the environmental problems are resolved, the tub should be drained. But by adding new accruals each year, companies are effectively leaving the faucet on. “What we don’t know is the true capacity of the tub, the cost to fully resolve these liabilities,” says Rogers, whose study attempts to estimate those costs using publicly available data.

Whatever a never-ending cleanup bill implies about actual damage done to the environment, such recurring drains on cash flow certainly hurt investors. “Unlike nearly every other income-statement line item, there is very little if any visibility into the annual charge for ‘probable and reasonably estimable environmental liabilities,'” complained JPMorgan analyst Stephen Tusa, who downgraded Honeywell for this reason in 2006.

“It’s Scandalous.”

Companies typically cite three reasons why their legacy cleanup reserves never drain: the difficulty of estimating cleanup costs, new discoveries of contamination, or new costs acquired through mergers. At some companies, however, those claims are belied by the steady rate at which they funnel money into environmental reserves, suggesting, critics say, that managerial discretion plays a large part in reserve calculations. (One company, ConAgra, paid $45 million in 2007 to settle Securities and Exchange Commission charges that it used environmental reserves as a “cookie jar.”) At best, the explanations mean that companies are themselves blind to a major internal drain on cash.

Despite what companies say, it isn’t difficult to accurately estimate the future cost of environmental liabilities, asserts Gayle Koch, a principal with The Brattle Group in Cambridge, Massachusetts. Koch says her firm regularly does so for both corporate and government clients. “Companies estimate liabilities all the time for insurance recovery, to get insurance, for mergers and acquisitions, and in divestitures,” she says. “Transactions go forward based on those estimates.” The problem isn’t the estimates, she says, but the disclosure.

“I’ve been in court cases where I’ve seen detailed cost recovery with very detailed distributions of costs,” says Koch. “And those same companies will disclose in their annual reports [only] the known minimum cost.”

Sanford Lewis, an attorney with the Investor Environmental Health Network (IEHN), an advocacy group, agrees that companies can and do produce accurate estimates of environmental costs — for internal use. A company that tells investors that it expects liabilities of $200 million during the next 5 years may advise its insurer to expect liability claims of $2 billion over a 50-year period, wrote Lewis in a recent report. “It is happening, it’s scandalous, and investors should be outraged,” Lewis told CFO.

Increasingly, lawsuits, bankruptcy proceedings, regulatory investigations, and independent research are revealing that companies often know far more about the cost of their environmental liabilities than they tell investors. For example, New York Attorney General Andrew Cuomo is currently investigating whether Chevron misled investors — including New York State’s pension plan — about the extent of its liability in a $27 billion lawsuit tied to “massive oil seepage” in Ecuador. Chevron is widely expected to lose the case in Ecuador but fight payment in the United States, and Cuomo has demanded that the company disclose estimates of potential damages and its cash reserves.

Litigation is bringing other environmental liabilities to light. In May, Tronox, a chemical company spun off from Kerr-McGee in 2006, filed suit against its former parent alleging fraudulent conveyance. According to the complaint, Oklahoma City-based Tronox claims that Kerr-McGee misled investors regarding the magnitude of the legacy liabilities it “dumped” on the spin-off, including environmental remediation costs. Tronox claims the liabilities left it “grossly undercapitalized” while the former parent sold itself to Anadarko Petroleum for a profit. The company filed for Chapter 11 bankruptcy protection last January. (Anadarko officials say that the suit has no merit and that the Tronox bankruptcy is unrelated to Kerr-McGee or the spin-off.)

Another chemical company, Solutia, emerged from bankruptcy in February. The Monsanto spin-off had inherited significant environmental liabilities from its parent. As part of its emergence, Solutia increased its environmental reserve from $78 million to $337 million, according to a spokesman.

Why Lowball Is Legit

If a company wants to lowball its environmental-liability estimates, accounting rules certainly make it easy. FAS 5 says companies must accrue for any loss that is “probable” — but only if the loss can be “reasonably” estimated, which means that a range of possible costs can be established. If a company concludes that no single price tag stands out, the rule says it may disclose the low end of the range. “That is mathematically wrong,” says The Brattle Group’s Koch. “If the whole range is equally weighted, math tells you to pick the average as the expected value.”

Ed Trott, a former member of the Financial Accounting Standards Board, agrees. He says that the low end of the range is the “least meaningful” measurement that companies could disclose. “Many accountants like to argue that they want conservative rules,” says Trott. “But FAS 5 is the opposite of conservative. FAS 5 is an embarrassment.”

At one point even the SEC seemed to agree. “In practice, zero may arguably be the low point of the range in many cases, resulting in no liability being reflected,” the SEC staff wrote in a 2005 report to Congress on off-balance-sheet accounting. But, “the Staff has long believed that the application of SFAS No. 5 by issuers should be improved.” (The SEC did not respond to repeated requests by CFO for a comment on its current position.)

Indeed, attorney Rogers believes FAS 5 actually forces company management in an awkward spot, both by encouraging a lowball disclosure and by discouraging efforts to openly obtain more-detailed estimates that might force them to hike the number. A low liability estimate can also prevent companies from pursuing other strategies, such as transferring the liability to insurers, which naturally would charge a higher figure. “People get locked into this pattern and can’t change,” says Rogers. “Auditors know this is kind of bogus, but the standard is kind of bogus, too.”

Last year, FASB proposed tightening FAS 5 so that companies would have to disclose all but “remote” loss contingencies and provide a full range of estimates. But the move triggered a storm of protest from attorneys, who feared that companies facing lawsuits would be forced to provide privileged information, and that the disclosures might reveal their defense strategies to plaintiff’s lawyers. Many cited a 1975 treaty between the American Institute of Certified Public Accountants and the American Bar Association that states that attorney-client privilege trumps auditor scrutiny. Much of The Brattle Group’s work for companies is stamped “Prepared at the request of counsel,” notes Koch, which effectively extends legal privilege to internal reports on environmental costs.

The protest appears to have killed FASB’s proposal, although at press time the standard-setter was officially still reviewing public comments. Among the minority who commented in favor of modifying FAS 5, most said unequivocally that the peculiar math of the standard and the ability of companies to shield contingent liabilities behind attorney-client privilege leave investors with far less information than is actually available. In his letter, Standard & Poor’s chief global accountant said the rating agency is regularly privy to inside information about contingencies that could affect cash flows, an effect “difficult to discern and quantify [using] public disclosures.”

More Cleanup Needed

Despite the criticism leveled at FAS 5, FASB seems unlikely to change it in the near future. The equivalent international rule, IAS 37, currently requires that firms provide investors with the midpoint, rather than the bottom, of a probable range of costs, a difference that would likely cause the environmental liabilities at American companies to soar if the United States converts to international accounting.

“Everyone is blaming FASB, but more often than not you find a lot more forward-looking information [about contingent liabilities] outside of the audited financial statements, which puts it outside of FASB requirements and mostly under SEC mandates,” says Kyle Loughlin, S&P’s team leader for the chemical sector, which covers companies included in Rogers’s analysis of reserves. He points out that much of the contingent-liability information is currently found in the footnotes or in the Management’s Discussion and Analysis section of the financial statements, as required by item 303 of the SEC’s Regulation S-K.

Rogers notes that most companies would be better off if they could publicly estimate the full value of their environmental liabilities, if for no other reason than to turn off an ongoing hit to earnings. To date, however, he says the best opportunity for companies to come clean is during a merger or acquisition, when different accounting rules apply.

The IEHN’s Lewis, meanwhile, is lobbying for an accounting rule that forces companies to release certain internal estimates that are often provided to insurance underwriters. “At a minimum there should be some level of disclosure to say, ‘We’re giving [investors] the known minimum, but we give a different figure to our insurers,'” Lewis says. “Either FASB or the SEC should issue a rule that says if a company is giving estimates of contingent liabilities to someone other than investors, it would be materially misleading not to also disclose the estimates [publicly].”

That’s unlikely to happen without a fight similar to the one over FAS 5 last year. But until more disclosure is mandated, investors will remain in the dark about the toxic liabilities that are eating away at corporate earnings.

Marie Leone is a senior editor at CFO. Tim Reason is editorial director of CFO.com.

The Truth about Reserves

A new study of public financial data for 24 oil, gas, and chemical companies shows that despite spending millions each year on cleanup, most of these companies take charges every year to replenish their environmental reserves. The study was performed by Greg Rogers, an environmental attorney and president of consulting firm Advanced Environmental Dimensions.

Of the 24 companies studied, 21 had a cash efficiency of less than 50 percent, meaning that they reduced their reserve by less than 50 cents for each dollar of cash spent on cleanup (see chart below). Nine companies actually had negative performance — that is, for each dollar they spent on cleanup, their reserves actually grew, as indicated by a negative cash-efficiency metric.

One company that fared well in the study was El Paso Corp. The oil company’s legacy environmental liabilities are chiefly related to hydrocarbon releases that contaminated facility soil and groundwater. Since 2001, the company has reduced its reserve from more than $500 million and a portfolio of 900-plus sites to less than $200 million and fewer than 500 sites. In 2008, its reserve shrank by 69 cents, net of mergers and acquisitions, for each dollar spent on site cleanup. “That result [is evidence of] the level of diligence that goes into our estimating,” says CFO Mark Leland. Each quarter the company performs a valuation analysis of every site and reflects the latest value of its liabilities in the company’s 10-Q.

El Paso doesn’t bother creating a range of potential costs. It calculates what it believes its actual costs will be and discloses them, along with a “worst case” scenario as required by SOP 96-1. “Whether the liability goes up or goes down, we put it in the books without regard to the P&L impact,” says Leland. — M.L. & T.R.